Tax-Free Bonds Offer Tempting Yields

Even after their recent rally, municipal funds could continue climbing this year.

NEW YORK ( TheStreet) -- As Washington struggled to sidestep the fiscal cliff last year, municipal funds sank. During December, the average intermediate tax-free fund lost 1.2%, according to Morningstar. Investors worried that Congress would undo some of the advantages of municipals. But since tax legislation passed on Jan. 1, the funds have gained back much lost ground.

The markets cheered the legislation because it did nothing to change the tax-exempt status of municipals. In addition, Congress raised the top tax bracket from 35.0% to 39.6%. That may be painful for high income earners, but it makes the tax exemption of municipal bonds more valuable.

To appreciate the impact of the tax rise, consider that the average intermediate-term municipal fund delivers a tax-free yield of 2.5%. In 2012, that yield was the equivalent of a taxable bond with a yield of 3.8% for investors in the top tax bracket. With top rates higher this year, the equivalent taxable yield has jumped to 4.1% -- a fat payout at a time when money-market funds yield almost nothing. "Demand for municipals has been strong because the yields are compelling," says Peter Hayes, who heads BlackRock's municipal group.

Even after their recent rally, municipal funds could continue climbing this year. Prices are still a bit depressed because of the uncertainty around the debt-ceiling negotiations, says Duane McAllister, portfolio manager of BMO Intermediate Tax-Free ( MITFX). Some investors worry that a final deal could limit tax advantages for high-income investors.

McAllister says that under normal circumstances, municipals should yield about the same or less than comparable U.S. Treasuries. But at the moment, 5-year AAA-rated municipals yield 0.87%, while 5-year Treasuries yield 0.78%. Nervous investors are demanding a premium before they will buy tax-free bonds. McAllister says that when Congress finally draws clear rules, prices of municipals could rise, and the yields would fall. "If we get beyond this uncertainty, there is room for municipals to do better," he says.

To take advantage of improving municipal markets, consider a fund with a record of steady performance. A top choice is BMO Intermediate Tax-Free, which returned 6.2% annually during the past five years, outdoing 96% of peers.